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Counterparty Risk In The Spotlight

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Inside Sibos | Day 1

September 29, 2014
Author:
Ronald Fink

Sibos attendees will discuss the implications of a vast array of regulations—including AIFMD, Dodd Frank, EMIR, UCITS, MiFID, FATCA, FTT. Dodd-Frank and Basel III—particularly during the new investment manager forum, on counterparty risk and collateral management. But what has really changed since the global financial crisis first hit?

Four years after the Dodd Frank Act was enacted in the US to help stem another bank crisis, one of the primary causes of the meltdown remains a serious concern. That is the interconnectedness of financial institutions. The fact is that one institution’s failure can still threaten to take others down, as we saw at Bear Stearns, Lehman Brothers and AIG, thanks to the exposures they have to one another through loans and other credit that banks have extended to their peers.

In the US, the Federal Reserve only this year started tracking counterparty risk through new reports that require the 33 “global systemically important banks,” or G-Sibs for short, to detail their exposures. As University of Massachusetts economics professor Gerald Epstein recently noted, the reports show, for example, that Morgan Stanley has the biggest counterparty exposure, at fully 65% of its assets. Six other large banks have exposures to other banks that are in excess of 10% of their assets. Goldman Sachs’ exposure is close to 40%.

Dodd-Frank was supposed to address this through the Volcker Rule, which gets banks out of the business of owning hedge funds, and with it, the lending activity known as prime brokerage. And that may help reduce counterparty risk going forward. The law’s provisions regarding derivatives may also help by requiring banks to post collateral to back their positions. Like the Volcker Rule, the derivatives rules only recently went into effect.

Even so, some observers worry that those measures in and of themselves will be insufficient. “Its not enough,” asserts Epstein, who with his University of Mass colleague Jane D’Arista has also written a paper on Dodd-Frank’s provisions that address counterparty risk, entitled “Dodd-Frank and the Regulation of Dangerous Financial Interconnectedness.” In it, Epstein and D’Arista note that the specific provisions require “rigorous enforcement and vigilant oversight,” requirements that could be difficult to fulfill.